Lender deception as a response to moral hazard

The paper considers a principal–agent relationship between a borrower and lender based on a model from Bowles (Microeconomics: behavior, institutions, & evolution. Princeton University Press, Princeton, 2003). It expands the model by incorporating borrower collateral as an exogenous variable to partly assuage lender concerns about excessive risk, and a theory of lender deception is then developed. Deception is posited as a costly activity that effectively makes fraud undetectable and extracts the borrower’s economic rent arising from moral hazard despite the presence of third-party enforcement and borrower collateral. We identify under what conditions a lender may have sufficient incentives for employing deception and to what extent they would employ it. The likelihood of, and outcomes from, deception are compared between monopoly lenders those in competitive markets. The model suggests that competitive lenders have more incentive to deceive than a monopoly lender facing the same borrower.